Real Options

What are Real Options?

Real options are a right but not an obligation to make a business decision. The concept of a real option is crucial to the success of a business as the ability to choose the right business opportunity bears a significant effect on the company’s profitability and growth. A real option allows the management team to analyze and evaluate business opportunities and choose the right one.

The concept of real options is based on the concept of financial options; thus, fundamental knowledge of financial options is crucial to understanding real options.

Types of Real Options

Real options may be classified into different groups. The most common types are: option to expand, option to abandon, option to wait, option to switch, and option to contract.

Option to expand is the option to make an investment or undertake a project in the future to expand the business operations (a fast food chain considers opening new restaurants).

Option to abandon is the option to cease a project or an asset to realize its salvage value (a manufacturer can opt to sell old equipment).

Option to wait is the option of deferring the business decision to the future (a fast food chain considers opening new restaurants this year or in the next year).

Option to contract is the option to shut down a project at some point in the future if conditions are unfavorable (a multinational corporation can stop the operations of its branches in a country with an unstable political situation).

Option to switch is the option to shut down a project at some point in the future if the conditions are unfavorable and resume it when the conditions are favorable (an oil company can shut down the operation of one of its plants when oil prices are low and resume operation when prices are high).

Pricing of Real Options

The NPV method is the most straightforward approach to real options pricing. For example, for an option to expand the business operation, we can forecast the future cash flows of this project and discount them to the present value at the opportunity cost. We will use the option if the NPV is positive and dismiss it if the NPV is negative. However, in a real-life setting, the NPV approach can be hard to perform correctly.

Fortunately, the pricing of financial options approaches can be applied to price the real options. Some real options behave similarly to calls; some behave similarly to puts. As for example, the option to expand can be viewed as a call option, while the option to abandon can be viewed as a put option.

In order to use the techniques for pricing financial options for real options, we should define the relevant variables.

Symbol

Financial Option

Real Option

S

Stock price

Expenditure required to acquire asset/Upfront investment

K

Strike price

Current value of asset/project

T

Time to maturity

Time before the opportunity expires

σ

Volatility

Riskiness of asset/project

r

Risk-free rate

Interest rate

Div.

Dividends

Cash flows from operations

Using the variables above, we can easily use the methods used for pricing financial options such as binomial model, Black-Scholes model, and Monte Carlo simulation to price real options.